Given the questions we’ve received in response to our Best 2 Ideas Article and our perspective on a widely circulated short thesis for OLN, we’d like to follow up with a “Part 2 – OLN” article to disprove several of the issues being raised in what appears to be an aggressive campaign of misinformation by certain players pushing this narrative. While certain articles discussing some of the below points have mysteriously been published in various media outlets, a simple analysis of the company and industry fundamentals can easily disprove this narrative.
NOTE: Chlorine and caustic soda (sodium hydroxide) are two of the most important commodity inorganic chemicals, and together are referred to as chlor–alkali.
Short Thesis Argument #1
Trough earnings – “The company will earn ~$600m in EBITDA during the next downturn as chloralkali profitability collapses.”
While shocking on the surface, this assertion can easily be disproved by simply looking at the current structure of the business and historical profitability.
1) Step 1 is to adjust for the MUCH larger capacity base after the DOW transaction – Olin’s chlor-alkali capacity more than doubled post-DOW.
2) Assume trough profit per unit of volume (EBITDA per ECU) in 2009 and apply this to the new capacity base, Olin will likely earn ~$560m in EBITDA from the chlor-alkali business alone during the next trough/downturn.
3) Conservatively assume ~$60m in Winchester earnings and ~$105m for Epoxy.
4) Add in already realized ~$275m in post-DOW synergies,
5) Add ~$100m in ethylene benefit through cost-based agreements with DOW (also realized given payments to DOW), ~$50m from an IT systems upgrade (2020), ~$75m from a new VCM tolling agreement, and ~$75m from already in progress debottlenecking. In sum, the new level of trough EBITDA for Olin exiting 2021 is likely ~$1250m, a level not too far from what the company is expected to earn this year in 2019. As of today, this makes OLN an incredibly compelling buy at ~5.5x trough EBITDA and 16% trough FCF yield.
Short Thesis Argument #2
At OLN’s recent Investor Day, independent, 3rd-party consultant IHS laid out the replacement value of the OLN asset base which shows the company is clearly under-earning relative to the replacement value of its assets. This is also consistent with other industry assessments that show reinvestment economics as cost prohibitive for adding new greenfield capacity at today’s product prices. At the same time, capacity in developed markets has been reduced for other various reasons – OLN shut capacity in North America due to low return on certain assets, and several million tonnes of capacity were closed in Europe as part of a phase-out of mercury-based chlor-alkali capacity. Given the current low return on assets coupled with higher prices simply due to better industry utilization, we find the price fixing argument does not hold any water. Finally and importantly, in a worst-case scenario, one needs only to look at other examples of similarly consolidated markets like containerboard and producer International Paper, where a similar suit was brought that took 7+ years to resolve and was ultimately settled for a small dollar amount by IP.
Short Thesis Argument #3
US domestic contract prices will collapse for caustic soda prices.
Domestic vs export prices – Lastly, there is some controversy about a recently wide spread between US domestic contract caustic soda prices and US export spot prices. The short thesis argues that this gap must close and US domestic contract prices will collapse. This is completely off the mark for a number of reasons.
1) These two markets are not directly fungible for simple logistical/infrastructure reasons.
2) This spread has been wide in the past only to shortly close within a matter of months with export returning to higher domestic contract prices
3) The recent wide spread was due to one-off factors like Braskem and Alunorte, both of which have now been resolved
4) Ask yourself, if you were a buyer of caustic in need of long-term, secure supply for a paper mill, alumina plant, etc., would you be willing to forego that security of supply in order to capitalize on a lower spot price that probably will not persist for more than a few months? It would seem highly unlikely.
Disclosure: I am/we are long OLN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.